MEANING AMORTIZATION- ALL YOU NEED TO KNOW

Amortization is a way to pay off debt in equal installments that include varying amounts of interest and principal payments over the life of the loan. An amortization schedule is a fixed table that shows how much of your monthly payment goes toward interest and principal each month for the full term of the loan.

Fully Amortized Loans

A fully amortized payment is one where, if you make every payment according to the original schedule on your term loan, your loan will be fully paid off by the end of the term.

Positive Amortization

Lenders typically require a borrower to repay part of the principal with each loan payment to reduce their repayment risk. This results in the loan balance decreasing with each payment. This is called positive amortization.

Negative Amortization

Negative amortization is when a borrower is making the required payments on a loan but the amount they owe continues to rise because the minimum payment doesn’t cover the cost of interest.

Positive Amortization vs Negative Amortization

Getting back to mortgages, all of the amortization discussed until now has been positive in nature. A typical mortgage loan is structured such that the principal balance decreases with each monthly payment. This is positive amortization.

Negative amortization occurs when the principal balance grows because the minimum monthly payment does not cover interest costs. The unpaid portion gets added to the principal amount each month and, as a result, the amount of the obligation increases. 

This can come into play with payment option adjustable rate mortgages. These instruments are structured such that investors can determine how much of the monthly payment is applied to interest costs. If the rate is higher than they elect to pay, the difference is added to the loan’s principal balance. 

Graduated payment mortgages also entail negative amortization. Under this approach, early payments include partial interest payments, the balances of which are added to the principal. 

While these strategies do give investors added flexibility, they can also make the loans more costly in the long run. 

What Commercial Real Estate Investors Should Know About Amortization

Commercial property real estate investors have another consideration to make when it comes to mortgages and amortization. Generally speaking, most commercial real estate loans require balloon payments at the end of their terms. Properties are typically financed with 10-year fixed interest rate loans, amortized over 25 to 30 years. 

The loan comes due at the end of the tenth year, at which point the principal balance must be paid in full. Investors will either sell the building when the balance comes due or refinance it. The resulting smaller monthly payment keeps costs lower, which improves the return on equity (ROE). This is why most commercial real estate investments are predicated upon carrying debt.

How to Invest in Real Estate

There are a number of different ways to invest in real estate. Among the more common are owning commercial and/or residential rental properties, joining a real estate investment group or participating in a real estate investment trust. Some investors purchase houses, rehabilitate them and sell them. Investing in a real estate mutual fund is another way to include this asset class in a portfolio.

Direct investments in real estate can be very “hands-on” experiences, unless the properties are turned over to a management company. While this does have the potential to reduce an investor’s physical involvement, it also increases costs. REITs, investment groups and mutual funds eliminate the need for such direct involvement.

Loan Amortization

The process of writing down a loan is referred to as amortization. An amortization schedule is employed to lower a loan’s balance as installment payments are made. In most cases, early loan payments are weighted more toward covering interest payments than reducing the loan’s principal. As time goes on, the balance gradually shifts so that more of the payment is applied to reducing the principal than covering interest payments.

With a fixed mortgage, multiplying the interest rate by the outstanding balance and dividing the product by 12 determines the interest payment. The percentage of the principal due that month is the difference between the established monthly payment and the amount of interest to be paid that month. As the term of the loan progresses, the principal amount becomes smaller, which in turn reduces the amount of interest due. However, because the total monthly payment remains the same, a larger percentage of it goes to reducing the principal balance. This pattern repeats throughout the life of the loan until a zero balance is achieved.